Security tokens: the third blockchain revolution

October 23, 2018

Away from the mania of last year’s ICO gold-rush, the appeal and benefits of raising capital by issuing debt and equity on a blockchain-enabled marketplace has struck a chord in the institutional financial services world. As momentum builds among some of the biggest names in finance, we will soon see properly regulated tokens, fit for real businesses and sovereign entities, writes R3’s Todd McDonald.

2017 saw a huge boom in companies raising money by issuing their own digital currencies, a process that has become known as an initial coin offering, or ICO. Holders of these coins, or ‘tokens’ are then able to freely trade them on online crypto exchanges.

ICO activity skyrocketed almost overnight, and by the end of 2017 start-ups had managed to raise a total of more than $5.6 billion[1]. Not bad for a market that barely existed a year earlier.

The potential for quick returns attracted a lot of investors, especially inexperienced retail investors spurred on by stories of crypto-millionaires. As might be expected, the risks associated with these investments were not always fully understood. There have been countless instances of scams[2], fraud[3]or outright Ponzi schemes[4], which would be seen as comical except for the fact that it put ‘other people’s money’ clearly at risk[5].

Unsurprisingly, the amount of money pouring into the sector means regulators are appropriately increasing focus on token issuance projects, particularly in the United States[6]. This, combined with a steep decline in deployable money from cryptocurrency speculation, has led to a clear cooling off period for ICOs[7].

However, the benefits of a decentralized issuance and transaction marketplace and smart securities contracts have clearly captured the attention of institutional players. 2018 has seen increased focus on security tokens, which offer the promise of spurring a new, lower friction method of asset and capital formation. These ‘enterprise-ready tokens,’ if developed appropriately, could automate or simplify much of the asset origination, issuance, execution, and secondary trading processes that make up so much of investment banking fees today. Issuers of securities everywhere see the value in a more efficient, effective connection to those looking to allocate capital, all in a safe, regulated and automated environment.

If bitcoin represented the first blockchain revolution and the emergence of enterprise blockchain platforms represented the second, the creation of a new global capital market powered by enterprise security tokens will usher in the third.

Putting assets on the chain

The first instances of these new enterprise token will likely focus on what is called asset-backed tokens. Put simply, the digital token represents an asset that is held ‘somewhere else,’ often at a regulated custodian. The token acts as a ‘digital twin’ and can be traded or exchanged freely on a blockchain with settlement finality, while the underlying asset remains blissfully in place at a custodian.

This interplay of a regulated custodian linked with an on-chain digital representation, while seemingly straightforward, unlocks new ways for markets to transact and expand. It offers a way for businesses to begin to iterate and implement enterprise-friendly yet novel digital assets, all from a strong foundation of an accepted regulatory base.

Building the token ‘buy-side community’

Both emerging and established financial infrastructure players are currently developing solutions to enable the issuance and secondary trading of these asset-backed tokens.

If tokens are to become credible and useful instruments in the institutional world, the quality and type of investor they are able to attract must also be considered. For example, when companies embark on a capital raise, whether it is a Reg D placement or full blown IPO, they (and their investment bank partners) seek ‘strong-hand’ investors – those that aren’t in it just for a quick profit.

The same will apply in the future for companies issuing their debt or equity as tokens, and as such they will seek out platforms that give them access and distribution to a buy-side of proven investors.

Corda: the natural home of security tokens

R3 is uniquely positioned to facilitate the emerging ‘token economy’ in a secure and regulated manner. The same enterprise-ready focus that led to the design and capabilities of our Corda platform can be extended to bringing the best innovations of the ‘wild west’ of the token world to the enterprise.

Corda was designed from inception to solve the problem of how to represent real-world agreements on a blockchain in a canonical and enforceable way, and this approach can be directly applied to security token issuance. Financial agreements on Corda take the form of smart contracts, linking business logic and data to associated legal prose in order to ensure that trades executed on the platform are rooted firmly in law.

Other key considerations for security token issuance, such as identity, security, data privacy and settlement finality, are already handled elegantly by Corda and have been key drivers in securing its position as the blockchain platform of choice in capital markets.

Corda-based token examples actually emerged back in 2016, when we began a collaboration with Bank of Canada, Payments Canada and others under the name Project Jasper, where a token called CAD-COIN[8] represented collateral held by the central bank. Since then, we have seen pilot and production examples from our partners, in particular from HQLAxin securities lending and Tradewind Markets in gold trading.

Connectivity with the established financial services community also differentiates Corda from any other platform in the space. R3 is already in talks with a number of major market infrastructure providers about creating regulated environments for security tokens, underpinned by Corda, and the 200+ member ecosystem includes most of the biggest names in financial services, giving token issuers access to a vast network of high quality investors. Corporates, banks, asset managers, and market infrastructure providers are also crowding in to provide a stable, regulated settlement asset on Corda. Corda’s unique design supports delivery of digital security tokens against payment in digital cash instruments in a single, atomic transaction. This will reduce time, cost, and perhaps most importantly, risk in the emerging token-enabled credit market on Corda.

Platforms like Corda provide the catalyst and foundation to enable security tokens to become a new and potentially invaluable tool in the capital markets toolbox. Unregulated ICOs provided the inspiration for this next wave, yet the shift is already underway to make tokens enterprise-grade. The third blockchain revolution of digital assets will arguably be the most important and impactful to date.